Friday, June 24, 2011
Sometimes you have to really dig into the entrails of the bond market to find important information. What this chart illustrates is that the changing shape of the yield is reflecting a rise in the market's near-term inflation expectations. One part of the yield curve that stands out is the spread between 10- and 30-yr Treasury yields; this has widened from a low of 102 bps in April to 130 bps today. At the same time, the 5-yr, 5-yr forward breakeven inflation rate embedded in the TIPS market (a sensitive measure of near-term inflation expectations that the Fed pays particular attention to) has risen from 2.4% to 2.9%.
Rising inflation expectations can also be seen in the above chart, which measures the spread between 5- and 10-yr Treasury yields. This spread is now as wide as it has ever been. This is a direct reflection of the Treasury market's fear that inflation is going to be higher in the second half of the next decade than in the first half.
The last time all of these measures of inflation expectations rose in tandem was in the Sept-Oct '10 period, as the market began to fear that QE2 (which began in November) would be inflationary, and the economy began emerging from its April-August '10 slowdown.
Consider the factors which have been driving the steepening of key parts of the Treasury curve. To begin with, the economy's sluggish growth of late, coupled with the market's lack of confidence that growth will improve in the future, have created the expectation that the Fed will keep short-term interest rates extremely low for at least the next year. The Fed of course has helped foster these expectations with its repeated use of the "extended period" language, and its ongoing concerns about weak growth, high unemployment, and deflation risks. Currently, the market does not see any appreciable chance of a Fed tightening until the third quarter of next year, according to Fed funds futures contracts. If the market's expectations are realized, the Fed funds rate will have been 0.25% or less for fully three and a half years—which would mark a truly unprecedented period of accommodative monetary policy.
With policy so easy for so long, the risks of an unwelcome rise in inflation become too big to ignore. No wonder the price of gold has doubled, to $1500/oz., since late 2008, and the dollar has dropped by 15%. No wonder the front part of the yield curve has never been so steep.
Even if real growth continues to disappoint, the economy still shows every sign of continuing to grow. I don't see why GDP can't post at least 3% growth for the foreseeable future, but that would of course leave the economy about 10% below its potential growth, and that in turn implies the unemployment rate will remain quite high for some time. And if inflation accelerates further—the year-over-year GDP deflator has already picked up from 0.2% in Sep. '09 to 1.6% in Mar. '11, and the CPI has gone from -2% in July '09 to 3.4% in May '11—then we will see a significant pickup in nominal GDP going forward.
Even with sluggish growth, a pickup in inflation and accelerating nominal GDP growth should be good news for equities, corporate bonds, and real estate. Rising nominal GDP provides a good foundation for further growth in corporate cash flows and profits, and increased cash flows plus higher inflation should eventually be good for real estate, especially since it has fallen so much in the past 5 years. (Normally I would include gold and commodity prices in the list of things likely to benefit from accelerating inflation, but they appear to have already anticipated a lot of that.)
Posted by Scott Grannis at 11:01 AM